What Exactly Is Money?

What Exactly Is Money?

By: Eric Johnson

On the surface, the question, “What is money?” seems easy to answer. We use our wallets’ green dollar bills and coins to make purchases. At a deeper level, though, the question enters a more perplexing stage. Money can come in a variety of formats. For thousands of years, precious metals were a form of money. More recently, money has been in paper bills and tiny coins.

Further, money can also be digital in our mobile banking accounts. So, how do you define money? And what are the functions of money?

Money is a unit of exchange that economies use to measure value in financial transactions. Money has four economic functions:

• Medium of exchange;
• The measure of value;
• Standard of deferred payments;
• And a means of storing wealth.

Think about a dollar bill in your wallet. Does it pass the test as a form of money? Let’s review the four economic functions to see if it does. First, you can use the dollar bill as a medium of exchange. You will notice prices on the shelves at the grocery store. The prices you see are usually in the country’s currency. The currency is the U.S. dollar in the United States of America. Your dollar bill is a part of the U.S. currency and, therefore, a medium of exchange.

How would you value an apple? Do you need to compute complex calculations to derive how much it costs? Do you need to barter some of your items for the apple? Centuries ago, some countries used a barter system to acquire goods and services. The main issue with bartering is the inefficiencies it places on buyers and sellers. Buyers need to have enough items to make a trade. Sellers must also know their item’s worth and determine what they want in exchange.

As you can see, this process could be more efficient as both parties may make several counteroffers before reaching an agreement. With money, you can place a sticker on an apple that shows its price to potential buyers. Money enables a price system in a market economy. And everyone benefits as financial transactions are much smoother and more coordinated. Once again, your dollar bill is part of the U.S. currency system that serves as a measure of value.

Suppose I made a loan with you for your one-dollar bill. I promise to repay you next week with the entire principal amount and interest. Money also serves as a standard of deferred payments. In one week, you can expect full repayment of the loan’s principal amount and any interest you charged for the loan. Your dollar bill represents a standard of deferred payments.

So far, your dollar bill has met the first three functions of money. What about the last function? Is your dollar a bill a means of storing wealth? Suppose you have a few extra dollars lying around in your house and decide it’s better to open a savings account at your local bank where you can securely store the dollar bills while earning a little interest on it until you need the money again. As you can see, your dollar bills are also a means of storing wealth. When you put money in a savings or brokerage account, you earn interest (and perhaps appreciation), which helps you keep your wealth for future use.

When developing a financial plan, it is essential to remember the vital function money serves. Since money is a unit of exchange for purchases, knowing how much you need for a new car, house, or retirement is helpful when developing a financial goal. But does having more money make you happy? Well, that depends.

Let’s return to economics for a moment to discuss the concept of utility. The utility is an economic concept that refers to the benefit or value a consumer receives from a good or service. In practice, more is always better. You always prefer more items of good than just one good. And that makes sense at a superficial low level. However, does your utility value increase or decrease as you acquire more goods? The subsequent interest will still make you happy; however, you will be less comfortable than before. Thus, your marginal utility declines on each additional good. You are still pleased with the next acquisition—a little less happy than before. Marginal utility is always positive. The marginal utility will, though, grow smaller with each additional good.

Our society is built on the premise, “If I were just a millionaire, everything would be great!” Each additional dollar you receive may make you less happy than before. Your marginal utility falls with each extra dollar in your possession. So, while you are still satisfied with the million dollars in the bank account, the next million you receive will probably not make you as happy as the first million.

Utility is a subjective measure of a consumer’s happiness. You will not go to dinner with your significant other and say, “This steak delivered a utility value of 15 tonight.” If you do, please let me know your partner’s reaction. Money is a fascinating topic, and there are more layers to peel. Hopefully, you now understand the four basic tenets of money and why more money may not make you happier.

Mr. Johnson is the Director of Financial Aid and an adjunct faculty member at Goldey-Beacom College.